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Economy

Quixotic Fed Policy and the Real Estate Cycle

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Over the past year U.S. mortgage rates have risen from sub-3% to over 7%. Unsurprisingly the nation’s real estate market is swooning; home sales are plummeting, inventories of new homes for sale are rising sharply and we are already starting to see signs that home prices are falling. Little doubt that most people over the age of 30 are suffering from some level of PTSD, remembering the economic carnage that came after the last collapse of the real estate market in 2007-08.

This real estate cycle and the last have similar roots — they were both created by bad policy on the part of the Federal government. The one bit of good news is that the underlying malfeasance in each cycle was completely different. Last time government policymakers did far too little, while this time it is fair to say they have done vastly too much. Ultimately, this means that this real estate cycle will have a much smaller negative impact on homeowners and thus the broader economy than the last one did.

The real estate cycle that generated the ‘Great Recession’ started with one of the greatest snake oil inventions ever dreamed up by Wall Street: the subprime mortgage-backed security. Regulators, believing in the economic myths of efficient markets and rational investors, sat idly by as trillions of dollars flowed into the housing market without any basic underwriting standards. The U.S. economy was overheated by the flood of bad debt and asset prices rose to unsustainably high levels driving both excessive consumer spending and housing investment. As with all pyramid schemes, this one eventually collapsed in on itself leading to a massive financial market mess, collapsed household net worth, and a recession that took over 8 years to fully recover from.

This time around the issue with regulators is not a lack of action, but rather too much. The Covid pandemic was a tragic human event but was never the existential economic crisis it was made out to be by too many economists and pundits. The result was one of the most preposterous overuses of stimulus ever experienced — in two short years the nation saw an enormous increase in Federal outlays funded by $6.5 trillion in fiscal borrowing. This was, in turn, funded by $5 trillion in new money delivered by the Fed in the form of quantitative easing despite the fact that the pandemic did not create any major financial problems. As a result, all this stimulus went straight into the money supply, and M2 ended up increasing by 50% in two years, faster than we’ve ever seen before.

When the money supply is expanded so dramatically and so quickly there is little mystery as to what happens — economists have studied such episodes since the very beginning of the social science’s existence two centuries ago. At first, because of money illusion, the excess liquidity creates a surge in economic activity—interest rates fall, asset prices rise, and consumer and business spending expand as a result. But inevitably this excess demand turns into inflation, which in turn causes interest rates to rise even as asset prices and spending fall.

And this is exactly what happened to the U.S. economy and why real estate markets find themselves where they are today. The excessive stimulus that began over two years ago caused mortgage rates to fall and household savings rates to increase. These two factors unleashed a massive amount of pent-up demand for homes into the market. Sales took off, tight inventories translated demand into bidding wars, and home prices leapt by over 40% in two years. None of this was sustainable because it was driven by excess money. Now inflation has kicked in, rates are rising, and the housing market is sagging.

But consider the differences between this cycle and the last one. The last cycle was driven by many years of excessive private borrowing, and the use of public stimulus occurred only after everything started to fall apart. This time the public stimulus was ultimately the driver of the housing bubble. It wasn’t private debt, but excessive public borrowing. Thus, the housing market that started to collapse in 2007 was marred by a very high debt-to-equity ratio, high household debt burdens, and an excess supply of housing. Today’s falling market has one of the lowest debt-to-equity ratios ever seen, low overall household debt burdens, and a very tight supply of housing following a decade of slow housing supply prior to the pandemic. Consider that at the start of 2007 U.S. households had $10 trillion in mortgage debt and $14 trillion in housing equity. Today the figures are $12 trillion in debt and $29 trillion in equity. In 2008, the U.S. housing vacancy rate was 2.8%, while in 2021 it was 0.9%.

Perhaps more importantly the last housing collapse occurred along with a collapse in overall consumer demand. They were highly linked during the Great Recession because it was the ease of obtaining mortgage debt that allowed consumers to overspend. This time around consumer demand is not being supported by debt accumulation but by the trillions of dollars in residual cash left over from the stimulus (household cash balances today are $4.6 trillion, compared to $1 trillion in 2018) combined with rapidly rising wages driven by a tight labor market. Hence, the drop in the housing market this time is occurring without a pullback in consumer spending and without the subsequent loss of jobs and income that hurts housing demand even more.

And this brings us back to the Federal Reserve and the current policies being pursued. Oddly, the Fed is acting as if inflation is hurting consumers, when in fact consumer spending is driving inflation. They are trying to stem inflation by jacking up interest rates, which will do little to cool base consumer demand (driven mainly by cash and earnings), and little to hurt homeowners who mostly have long-term fixed rate mortgages.

It is, however, hurting asset markets more than would be the case had the Fed just let inflation burn out on its own. And this is causing even more pain for housing assets. Still, this will not turn into a complete economic rout because the consumer is largely immune to the Fed’s efforts outside of falling asset prices. Yet again the Fed is pursuing the wrong policy and ultimately will do more harm than good.

But this harm is not as bad as the harm that was caused by looking the other way at Wall Street’s transgressions in the last cycle. Home prices may fall over the next year or two, but rental prices for housing will almost assuredly continue to increase at the same time given strong consumer demand. If we had to sum it up, the housing market of 2009 had too few buyers. The housing market of 2023 will be marked by too few sellers. The net result will be almost no foreclosures, limited price declines, and little in the way of household financial problems created the last time around. But it will be a very cold market for a while… at least until we get used to higher interest rates and begin to realize that not every negative shock is an existential crisis.

As my parents used to tell me in my teenage periods of angst: We are in danger of imminent survival.

Christopher Thornberg founded Beacon Economics LLC in 2006. Under his leadership the firm has become one of the most respected research organizations in California serving public and private sector clients across the United States. In 2015, Dr. Thornberg also became Director of the UC Riverside School of Business Center for Economic Forecasting and Development and an Adjunct Professor at the School. An expert in economic and revenue forecasting, regional economics, economic policy, and labor and real estate markets, Dr. Thornberg has consulted for private industry, cities, counties, and public agencies. He became nationally known for forecasting the subprime mortgage market crash that began in 2007, and was one of the few economists on record to predict the global economic recession that followed. Dr. Thornberg holds a Ph.D in Business Economics from The Anderson School at UCLA, and a B.S. degree in Business Administration from the State University of New York at Buffalo.

Career & Workplace

California’s Worker Shortage Struggle Continues…And Likely to Continue in 2023

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Job Growth Modest In Latest Numbers; Unemployment Rate Unchanged

California’s labor market expanded modestly in the latest numbers, with total nonfarm employment in the state growing by just 16,200 positions during December, according to an analysis released jointly by Beacon Economics and the UCR School of Business Center for Economic Forecasting and Development. November’s gains were also revised down to 19,900 in the latest numbers, a 6,900 decrease from the preliminary estimate of 26,800.

Overall, California added jobs at a healthy pace in 2021 and 2022. As of December 2022, the state had recovered all of the jobs that were lost in March and April 2020 at the pandemic’s outset, and there are now 70,000 more people employed in California compared to February 2020. Over this time, total nonfarm employment in the state has grown 0.4% compared to a 0.8% increase nationally. California’s economy increased payrolls by 3.6% from December 2021 to December 2022, outpacing the 3.0% increase nationally over the same period.

“During the year, California’s employers added jobs more quickly than was the case in the national economy, but labor shortages in the state dampened job growth towards the end of the year and will continue to be a drag on job growth in 2023,” said Taner Osman, Research Manager at Beacon Economics and the Center for Economic Forecasting.

Indeed, the state’s struggle to add available workers continues. In December, the state’s labor force contracted by 26,800 workers. Since February 2020, California’s labor force has fallen by 313,600 workers, a 1.6% decline. This lack of workers made it difficult for some employers to bring on the additional staff they typically recruit during the holiday season. California’s unemployment rate held steady at 4.1% in December, unchanged from the previous month. While this figure is near historic lows, the state’s unemployment rate remains elevated relative to the 3.5% rate in the United States overall.

Industry Profile  

  • Employment in nearly half of the job sectors in California now exceed their pre-pandemic levels; sectors that were hit the hardest by the pandemic have yet to recover all the jobs that were lost.
  • Health Care led job gains in December, with payrolls expanding by 8,900. Health Care payrolls are now 4.4% above their pre-pandemic peak.
  • Other sectors posting strong gains during the month were Construction (7,500), Government (6,000), Leisure and Hospitality (5,300), Professional, Scientific, and Technical Services (4,500), Other Services (1,300), and Real Estate (1,100).
  • Retail Trade (-9,500) posted the most job losses during the month. Other sectors with significant job losses were Information (-6,100), Wholesale Trade (-2,000), and Administrative Support (-1,900).

Regional Profile

  • Regionally, job gains were led by Southern California. The Inland Empire saw the largest increase, where payrolls grew by 9,400 (0.6%) during the month. San Diego (8,600 or 0.6%), Orange County (4,300 or 0.3%), Los Angeles (MD) (2,100 or 0.0%), and Ventura (1,200 or 0.4%) also saw payrolls jump during the month. Since April 2020, the Inland Empire (140.8%) has experienced the strongest recovery in the region, followed by El Centro (115.3%), San Diego (105.1%), Orange County (100.0%), Los Angeles (MD) (94.7%), and Ventura (91.5%).
  • In the Bay Area, San Francisco (MD) experienced the largest job increase, with payrolls expanding by 6,400 (0.4%) positions in December. The East Bay (3,100 or 0.3%), San Jose (1,800 or 0.2%), Santa Rosa (800 or 0.4%), San Rafael (MD) (600 or 0.6%), Vallejo (500 or 0.4%), and Napa (400 or 0.6%) also saw payrolls expand during the month. Since April 2020, San Jose (105.3%) has experienced the strongest recovery in the region, followed by San Francisco (MD) (96.1%), the East Bay (92.6%), Santa Rosa (88.3%), Napa (79.4%), Vallejo (74.3%), and San Rafael (MD) (55.5%).
  • In the Central Valley, Sacramento experienced the largest monthly increase, as payrolls expanded by 2,800 (0.3%) positions in December. Payrolls in Fresno (1,400 or 0.4%), Visalia (500 or 0.4%), Chico (300 or 0.4%), Modesto (300 or 0.2%), Merced (200 or 0.3%), and Madera (100 or 0.2%) increased as well. Since April 2020, Stockton (147%) has experienced the strongest recovery in the region, followed by Visalia (135%), Madera (124%), Merced (122%), Sacramento (115.7%), Fresno (114.4%), Redding (113.9%), Hanford (110.3%), and Yuba (110%).
  • On California’s Central Coast, San Luis Obispo added the largest number of jobs, with payrolls increasing by 900 (0.8%) during the month. Santa Cruz (600 or 0.6%), Santa Barbara (600 or 0.3%), and Salinas (400 or 0.3%) experienced payroll declines during the month. Since April 2020, Santa Barbara (103.6%) has enjoyed the strongest recovery in the region, followed by San Luis Obispo (100%), Santa Cruz (91.6%), and Salinas (84.3%).
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Economy

Pandemic Left Behind, the Inland Empire Economy Flourished in 2022

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A Driving Force: Local Transportation and Warehousing Industry Has Helped The Region Outperform Other Areas

Despite the recession drumbeat getting louder in many quarters across the nation, the Inland Empire’s economy is not only showing strength, but is outstripping California’s other major metros and the state as a whole along some very key measures, according to an analysis released today by the UC Riverside School of Business Center for Economic Forecasting and Development.

From employment to the labor force to consumer spending to wages to commercial and residential real estate, the Inland Empire has been a relative standout as the COVID-19 crisis fades further into the past. In particular, the pandemic-driven surge in e-commerce has pushed the region’s Transportation and Warehousing sector to new heights, boosting payrolls by more than 41% since February 2020, which outpaces growth in the state by a wide margin.

“This sector has long been one of the Inland Empire’s core industries and, ultimately, has been a driving force behind the region’s better and faster recovery,” said Taner Osman, Research Manager at the Center for Economic Forecasting and one of the report’s authors. “Moreover, the enduring shift towards online purchasing has intensified ongoing demand for the industry’s services, which bodes well for the Inland Empire as there is such a strong base and existing infrastructure already on the ground.”

Key Findings: 

  • Labor Market Fully Recovered… And Growing: The Inland Empire has more than recovered the 228,700 jobs it lost due to the pandemic’s shutdowns. Since April of 2020, the region’s economy has added more than 316,000 jobs, outpacing both the state and the nation. Regionally, total non-farm employment has grown 5.5% since February 2020 compared to just 0.2% in California and 0.5% in the United States.
  • IE Labor Force Growth A Standout: Unlike other areas of California, the Inland Empires’ labor force (individuals willing and able to work) has grown steadily. From February 2020 to October 2022, the region’s labor force rose by 75,800 workers, a 3.6% increase. California’s labor force, on the other hand, declined by -1.3%, or -256,900 workers.
  • IE Wage Growth Besting Other Areas… Then There’s Inflation: From 1st quarter 2021 to 1st quarter 2022 (the latest data available), wage growth in the Inland Empire (4.6%) has significantly outpaced California overall (1%). Local wage growth was stronger in San Bernardino County (5.2%) compared to Riverside County (3.9%). However, importantly, real wages fell -2.9% over the last year due to high inflation.
  • Consumers: Spend, Spend, Spend!: From 2nd quarter 2021 to 2nd quarter 2022 (the latest data available), taxable sales receipts in the Inland Empire jumped a hefty 9.5%. With fuel prices near record highs earlier in the year, and more people traveling for work and leisure, spending at Fuel and Service Stations was the region’s fastest growing taxable sales category, surging 39.2%.
  • IE Warehouse Space Now More Expensive Than OC and San Diego: The trends occurring in e-commerce have caused the demand for Warehouse and Distribution space to surge in the Inland Empire. The vacancy rate among these properties fell to 1.1% in the 3rd quarter of 2022 as asking rents ballooned 92.4%. While warehouse space in the region is still more affordable than it is in Los Angeles County, it is now more expensive than in Orange and San Diego Counties.
  • Housing Market Blues Not So Blue: Although today’s elevated mortgage rates are constraining demand, home prices in the Inland Empire continue to rise. From November 2021 to November 2022, the region’s median home price rose 3.5%, stronger growth relative to Los Angeles (-0.5%) yet slower compared to Orange (10.8%) and San Diego (6.3%) Counties.
  • Rental Market Surges: Demand for apartments in the Inland Empire is also booming. The apartment vacancy rate fell to 2.9% in the 3rd quarter of 2022 as asking rents jumped 7.9% to $1,854 per unit, per month. But even with that increase, the Inland Empire remains a more affordable rental market than Los Angeles ($2,358), Orange ($2,499), and San Diego ($2,247) Counties.

The new Inland Empire Regional Intelligence Report was authored by Osman and Senior Research Associate Brian Vanderplas. The analysis examines how the Inland Empire’s labor market, real estate markets, and other areas of the economy have recovered from the COVID-19 pandemic and their outlook for the remainder of the year.

View the full analysis here.

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Economy

Greatest Risk to Today’s Economy? The FED Despite Turbulence, Recession Remains Unlikely in 2023

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Today’s Maladies Are Symptoms Of A ‘Stimulus Hangover’ Not Drivers Of A Downturn; California Finally Recovers All Jobs Lost To Pandemic

A leading economic forecast does not see a downturn in 2023 as assured, or even likely, as long as the Fed doesn’t drive one. According to Beacon Economics‘ latest outlook for the United States and California, today’s ailments are symptoms of a hangover from the over stimulus that was injected into the U.S. economy during the pandemic, not signs of deeper weakness or triggers of a near-term recession.

Today’s economy is running at full speed, the exact opposite of what economists call a recession, when an economy produces less than it is able,” said Christopher Thornberg, Founding Partner of Beacon Economics and one of the forecast authors. “The United States is not struggling with a lack of demand; we’re struggling to meet demand.”

The new forecast points to the fact that the U.S. economy has added 4 million payroll jobs since the start of the year, that the unemployment rate remains well below 4%, that the job openings rate is well above its pre-pandemic peak, that industrial production is at a record high, that manufacturing orders are still rising as inventories remain low, that corporate profits have started to climb, and that consumers continue to spend, spend, spend – all signs that the economy is operating at capacity.

According to the outlook, today’s maladies of high inflation, declining asset prices, rising interest rates, and a turning housing market are symptoms of an economy ‘cooling’ back to normal after being overstimulated by the Federal government during the pandemic, not any fundamental deficiency in the system. Indeed, some of what is happening today is bringing numbers that hit record high levels over the past couple of years, such as stock market values and housing prices, back down to earth.

“Stock markets today are still 15% to 20% above where they were pre-pandemic, and even if home prices fell by 20%, which is highly unlikely, they would still be 20% above where they were before COVID hit,” said Thornberg. “Some of this is a recalibration – we need to recognize that and not panic.”

However, the new outlook’s call for ‘no recession in 2023’ comes with a big caveat: the Federal Reserve. If the Fed continues to raise rates until something truly snaps in the lending markets, they could needlessly drive a downturn, according to the forecast. If, on the other hand, they start to moderate, the economy will likely ride out the bumps caused by inflation and asset price declines and achieve the proverbial ‘soft landing’, meaning that the post-pandemic expansion will continue, but at a slower rate.

“While we don’t see a recession as an assured outcome as many other forecasts have suggested, we certainly acknowledge that bad choices by policymakers in the months ahead could set one off,” said Thornberg. “Today’s economy is indeed fragile and highly susceptible to a large negative shock, such as rapidly rising rates, but that die is not cast yet.”

Additional Key Findings: 

  • In the housing market, there is no debt crisis behind today’s repricing (unlike prior to the Great Recession) meaning it won’t have much of an impact on the broader economy. What happens in real estate will stay in real estate this time around.
  • U.S. households are sitting on over $4 trillion in checking account balances, almost five times as much as pre-pandemic. Consumer demand will remain strong based on wealth effects alone, which will help carry the economy into 2023.
  • Consumers may be starting to indulge in too much new debt, but the rapid interest rate spike will prevent a dangerous build-up.
  • While the overall consumer economy is healthy, inflation causes transfers of real wealth—from savers to borrowers, from those on fixed incomes to those on variable ones—and some households will be hurt.
  • California reached a key milestone in October 2022: The state finally recovered all the jobs lost due to the pandemic-driven shutdowns. Because of its heightened worker shortage, it reached this goal more slowly than the U.S. as a whole and more slowly than many other states. “Typically, there are more unemployed workers in California than there are job openings, but since the outbreak of the pandemic, that status quo has been turned on its head,” said Taner Osman, Research Manager at Beacon Economics and one of the forecast authors. “Today, employers in the state are struggling to hire the workers they need.”
  • Currently, the number of homes that have sold in California stands at around half the level it was in 2021 and is approximately one-third lower than during the years immediately prior to the pandemic.
  • The pandemic has accentuated one of California’s most troubling long-term trends: the divide between coastal and inland regions. Since 2000, the number of housing units in the state’s inland communities has grown at three times the rate of coastal communities; at the same time, inland communities have added jobs at three times the rate of coastal areas.

View the new The Beacon Outlook including full forecast tables here.

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